Gamma Airlines has an asset beta of 1.5. The risk-free interest rate is 6%, and the market risk premium is 8%. Assume the capital asset pricing model is correct. Gamma pays taxes at a marginal rate of 35%. Draw a graph plotting Gamma’s cost of equity and after-tax WACC as a function of its debt-to-equity ratio D/E, from no debt to D/E = 1.0. Assume that Gamma’s debt is risk-free up to D/E =.25. Then the interest rate increases to 6.5% at D/E =.5, 7% at D/E =.8, and 8% at D/E = 1.0. As in Problem 21, you can assume that the firm’s overall beta (βA) is not affected by its capital structure or the taxes saved because debt interest is tax-deductible.
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